The dominant refrain of those who would rein in corporate criminal law enforcement is that such enforcement unduly impacts innocent shareholders.

But are shareholders so innocent?

Columbia Law Professor John Coffee argues – maybe not.

“Since at least the time of Adolf Berle and Gardiner Means, it has been assumed that shareholders lacked the power to control management, because shareholders were too dispersed and the exercise of control was too costly for them,” Coffee writes in a recent paper presented at a conference at Georgetown Law Center last month.

“This assessment, of course, was summarized in their famous phrase about the ‘separation of ownership and control,’ which they dated to the early 20th century. The federal securities laws, enacted in the 1930s, sought to reduce this separation, but probably had only modest success.”

“What later changed was not the law, but the economics. Institutional investors arose, from a modest beginning in the 1950s to the current era in which they dominate corporate ownership,” Coffee writes.

“In the case of large public corporations (such as those in the S&P 500), institutions today hold on average over 70% of the stock. Even more importantly, this ownership has become highly concentrated, with the Big Three (the three largest asset managers in the U.S.) now owning over 23% of the equity in large corporations. Add a few more mutual funds and pension funds to the Big Three, and absolute voting control has been assembled.” 

“Until relatively recently, these shareholders were reticent about involving themselves in corporate governance at portfolio companies, but that too is changing, as they now regularly involve themselves in proxy fights and even litigation.”

“What is the relevance of this transition? If a partnership, in which five or six partners held 80% of the equity, were convicted of a crime, few would be shocked that most of this penalty fell on those five or six individuals. We understand intuitively that costs flow through the partnership to its partners. What then is different about convicting another legal entity (called a corporation) in which a small number of institutional investors also hold control? Again, on conviction, the penalty flows through to these owners – up to the ceiling set by limited liability. The main difference in the case of the corporation is that the shareholders have the protection of limited liability – and, in the case of public corporations, the shareholders are largely institutional investors and highly diversified, so that the penalty will be evenly spread across their beneficial owners, without disproportionate impact on any one such owner.”

“Under Delaware law – which applies to the majority of large corporations – control is easily exercised by those who own a majority of the stock. Unless there is a contrary provision in the corporation’s certificate of incorporation, such a majority can simply sign and deliver an instrument to the corporation that removes directors (or the entire board) and appoints new directors.”

“To be sure, these large shareholders probably did not know of the crime in advance, but that may be because they were rationally apathetic about it. Today, they hold the power to control, but exercise it only in exceptional cases.”

“In their defense, the largest institutional investors believe they simply own too many stocks to be able to monitor each stock in their portfolio closely. State Street Global Advisors, which is one of the Big Three, currently owns 10,000 stocks on a long-term basis – meaning that it and similar large investors rarely sell or “exit” from their investments. That they do not monitor these firms more closely, however, may be simply the consequence of the fact that they have little economic incentive to do so. If corporate criminal penalties were much higher, their incentives might change. No proposal for strict liability on shareholders is here made, but we have identified a leverage point on which additional pressure could be placed with the reasonable belief that it would generate sufficient pressure on management to make corporations more law compliant.”